Are your mutual fund fees so high you can't retire ?

This article was first posted on October 1, 1998. Last update on April 12, 1999

How do mutual fund fees and other investment expenses effect the maximum safe withdrawal rate in retirement ? High fees and commissions can place a big drag on the performance of your investments. If your investment expenses are too high, they may even prevent you from retiring at all.

Table One shows the maximum 100% survivable inflation adjusted annual withdrawal, for various levels of investment expenses. (See, "How do I calculate my investment expenses?" The maximum 100% survivable inflation adjusted annual withdrawal is the largest sum that can be withdrawn from the portfolio each year yet still have the portfolio survive to the end of the 30 year pay out period. This analysis is based on historical stock market returns from 1871 to 1998 collected by Yale University Professor of Economics Robert J. Shiller. The study assumes a 30 year pay out period and a portfolio of 75% stock and 25% fixed income securities, rebalanced annually. The annual withdrawals are adjusted annually for inflation / deflation. The table also shows the median and 25th percentile terminal values of the portfolio at the end of the 30 year pay out period. (Note: The 25th percentile terminal value is the value that is exceeded by 75% of the 30 year pay out periods considered.) For the details of how this study was conducted, click here.

An expense ratio of 0.02% would only be achievable on a "do-it-yourself" basis. This would mean using direct purchase bank CDs or US Treasury securities for the fixed income portion of the portfolio and a diversified collection of 15 to 20 S&P500 stocks bought through a deep discount broker for the stock allocation. You should have an account value of at least $100,000 before attempting this strategy. (See,"Should I invest in mutual funds or individual stocks and bonds.") Less than that, and an index fund would have less fees and less headaches.

Using a low fee mutual fund provider such as Vanguard , USAA, or TIAA-CREF should allow you to assemble a portfolio with an expense ratio approaching 0.20%. A short to intermediate term US Government bond fund could be used for the fixed income portion while the popular S&P500 index fund would be a good choice for the stock portion. Even retirees with sizeable portfolios (i.e., more than $200,000) may prefer this approach since it requires little ongoing maintenance.

The average mutual fund has an expense ratio of more than 1.00%. If you're paying anything close to this you should seek out some of the low fee alternatives. Not only will this allow you to increase your "100% survivable" annual withdrawal, but the terminal value of your portfolio will be higher as well. If you started with $1 million, you have an even chance of being $800,000 richer at the end of 30 years if you use an index fund with a 0.20% expenses ratio rather than an actively managed fund with a 1.00% expense ratio.

High fees and commissions really hurt.

You would probably have to have a variable annuity, a "wrap account" with a full service broker, or a financial planner charging a fee of 1% of assets in addition to your mutual fund management fees to reach an expense ratio of 2.50% or more. You'll also need to be very wealthy if you expect to retire. These types of fee arrangements will easily reduce your "100% survivable" annual withdrawal by 1% or more. As Table One shows, that's a 25% to 50% reduction in retirement income compared to what you could have safely withdrawn from an index fund. The terminal value of your portfolio will also be far lower (50% to 72% lower!) under this scenario.

If anyone tries to sell you any of these high fee "investment products" - RUN! If you're already in a variable annuity, surrender charges and the tax consequences of switching out may mean your trapped. Consider putting any new retirement savings in a low fee alternative. If you're in a "wrap account" or have a financial advisor charging 1% of assets rather than a hourly fee, you really need to evaluate the wisdom of that arrangement.

Forbes magazine also had a very enlightening article on financial planners. (See, "Forbes Magazine - Bedlam (06/15/98)" Forbes hired five highly recommended and impressively credentialed financial advisors to prepare a comprehensive financial plan for a 52 year old executive with a net worth of about $2.0 million. The fees charged for preparing these plans ranged from $1,500 to $3,500. Forbes also prepared a plan for our executive using Intuit's Quicken Suite 98 (Retail cost after rebate: $70.) Not surprisingly, the advice ranged all over the map. One planner said put 76% of assets in stocks, another only 20%. The Quicken software advised an asset allocation somewhere in between. The moral of this story? It's important for investors to understand that like soothsaying and tarot card reading, financial planning is not a science. As a result, you shouldn't overpay for these services.

What's the most reasonable interpretation of this data ?

Minimizing expenses is one of the surest paths to investment success. Since most mutual fund managers and "financial advisors" under perform the S&P 500, it doesn't make sense to pay a lot for their "expertise." Even a 0.50% management fee costs a lot in terms of reduced retirement income and the eventual size of your estate. Spending the small amount of time required to learn about financial markets and managing your own retirement assets should reap significant rewards.

A 100% survivable withdrawal rate is very conservative. You could choose a higher rate with little additional risk.

This study is based on historical data. The fine print here should read "past performance does not guarantee future results." While there is every reason to believe that investment returns in the next 125 years will be similiar to the previous 125 years, there's little chance it will be EXACTLY the same. To say that 3.89% is a "safe" withdrawal rate and that 4.00% will leave you broke implies a measure of accuracy in the forecast that just isn't there. It may make more sense to say that the "safe" withdrawal rate going forward lies somewhere in the range of 3.25% to 4.25%. Even a 5.00% inflation adjusted withdrawal rate has about a 90% survivability.

Low withdrawal rates will leave you with a large estate.

While a 4.0% withdrawal rate protects you against running out of money, it leaves you a very good chance of accumulating a large net worth. For someone starting with a $1.0 million account, 75% stocks/25% fixed income, 0.20% investment expenses, a 30-year payout period and a 4% inflation adjusted withdrawal rate, there is a 75% chance your account will be worth at least $2.4 million at the end of 30 years. Indeed, the authors of the Trinity study admit low "safe" withdrawal rates "cause a suboptimal exchange of present consumption for future consumption."

Surprisingly, even high investment expenses average out over time.

One interesting finding of this study was the fact that a 1.00% increase in investment expenses resulted in only about a 0.50% reduction in the 100% safe annnual withdrawal rate. Why doesn't it reduce the "safe" withdrawal by the full 1.00%? The answer is that when investment expenses are calculated as a percent of assets, the dollar amount collected annually by the financial advisor decreases as the account balance declines. The 100% maximum safe withdrawal rate is the rate that causes the account balance to approach near zero at the end of 30 years. So our financial advisor is also collecting a negligible advisory fee in the final year. Even the highly trained minds on Wall Street have yet to devise a way to draw blood from a turnip. A retiree with a $1.0 million account paying a 1.00% management fee would pay $10,000 in fees the first year and almost nothing the last year when the account balance reached zero. Over 30 years the annual fee collected by the advisor would average out to be about 0.50% of the original $1.0 million account balance.

There may be a place for financial advisors, but watch the costs.

If you decide you need professional advice, it's often cheaper to pay by the hour. Avoid arrangements that charge a "percentage of assets" under management. A 1% fee on a $500,000 account is $5,000 per year. Even an hour or two with a planner that charged $250 an hour would be a small fraction of that. Any savings in investments expenses effectively boosts your returns and increases your 100% survivable annual withdrawal in retirement.